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June 15, 2011

Donor Advised Funds: Maximize the Tax Benefits, Build a Legacy

More On Tax Planning

from The Advisor's Professional Library

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The use of ETFs may be attractive to certain investors. The tax advantages may make them even more attractive.

Annuities: Variable Annuities
Annuities are hot. The tax rules vary with the circumstances. Advisors must be aware of these intricacies when discussing annuities with clients.

While many investors over the age of 70½ cringe over the tax burden from their yearly required minimum distribution from their IRA, some individuals look to donate that distribution to charity.

As I wrote in one of my previous articles, “Cash Flow Change Generates Tax Deduction,”I outlined a distinct difference between taking an IRA distribution and donating it to charity, versus an investor using a qualified charitable distribution from an IRA to maximize the full tax deductible benefit of the charitable gift. From my experience, clients struggle with these options.

I believe one of the main reasons is the investor’s desire for more control over their charitable dollars, which, in some cases, generates the need to create their own private foundation. While most individuals may view private foundations as only available to ultra-wealthy families, that assumption is not exactly true. While it is true that these families have more reasons to create a private foundation due to the nature of their financial complexities, it doesn’t mean other families don’t have the same access to creating their own foundation.

A donor-advised fund allows any person or family to create their own version of a family foundation. Through firms such as the Fidelity Charitable Gift Fund,any investor can open a giving account similar to a family foundation. The client gets a full tax deduction for any gift made to their own giving account, and they can grow it and invest it, as well as request charitable distributions to their favorite charities over various years, months or other time periods. The best part about this is that an investor has no administrative responsibilities related to IRS compliance, as the main independent public charity takes care of all the related compliance.

So the benefit that a donor-advised fund offers investors that want to give to charity from their IRA is that a client can take their yearly required minimum distribution, and contribute the full amount to their own donor-advised fund – and it’s fully tax deductible. The client gets a tax deduction against the IRA income,

possibly creating a tax return wash. The only difference is that the IRA distribution increases a client’s adjusted gross income (AGI) and the charitable deduction could be limited on schedule A, subject to limitations and income phase-out rules. It would be great for a client to do a qualified charitable distribution directly to their own donor-advised fund. However, that’s not allowed under current law, so the only IRA funding option to a donor-advised fund has to come from a fully taxable distribution.

Some advisors might ask why, if clients have the option of doing a qualified charitable distribution from their IRA, they would do it any other way? I completely agree; however, many clients want to create a charitable legacy for their family and they feel the need to be involved. Secondly, under the current law, the qualified charitable distribution options expire December 31, 2011. Therefore, the option I mentioned may not be the most tax advantageous today, depending on each client’s overall tax situation, but it does allow a client to have more control in the form of creating their own “family like private foundation.”

A client’s family can create a plan to grow and distribute their charitable assets over whatever timeframe they choose, allowing a form of perpetuity. They can contribute annually to their own donor-advised fund, which is fully tax deductible, allowing them, over time, to grow a charitable legacy in which even their children and grandchildren can be involved. Furthermore, it allows for anonymous charitable giving, which for some individual clients is very important, not to mention large private foundations.

One thing I’ve learned as a tax professional is that even when the tax deduction benefits are great, clients are always willing to pay a little more if they can retain some control, even with their charitable assets. Therefore, for any client age 70½ or older making annual charitable gifts, regardless of income levels, this may actually be the direction to take, especially if a family charitable legacy is important, but the expense of a private foundation is out of the question.